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Reporting to management.

As part of the 2012 curriculum at NACM'S Graduate School of Credit and Financial Management, first-year students split into work groups and chose a topic for development to present during their second year. The purpose of this project was to create a blueline, framework or master checklist of key processes--the best practices--that would support the makings of a great credit department and the decision making within. "Reporting to Management" is one such project.

If credit departments use these projects to benchmark operations, it is hoped companies will recognize that their credit professionals are making decisions based on broadly embraced practices, and their customers will know they are doing business with a company grounded on what's "best in class."

Reporting is delivered to the senior management, executive management or management team--generally the team of individuals at the highest level of organization management who have the day-to-day responsibilities of managing a company or corporation, and hold specific executive powers conferred to them with and by authority of the board of directors and/or the shareholders.

Companies have different approaches to management reporting for credit and collections, and must determine what the right measures are and how often reports should be generated and reviewed. A meaningful measure fills a need and meets a specific objective. For a measure to be meaningful, it must be compared to some standard, which can be set according to past organization or industry values or trends. The right measure will express a value that complements and supports the objectives and mission of the company, division, department or subgroup.

The statement that a sale is not complete until the cash is in the bank is both familiar and true. A business organization would soon run out of operating capital if it were not continuously replenished through the collection of its receivables. Unless receivables are converted to cash on schedule, some of the company assets are unproductively tied up. Therefore, CFOs are concerned about credit and collections' impact on working capital, and rely on accurate and informative reporting to understand the health of the business.

Credit and collections reporting can be categorized into two general sections: cash flow forecasting and working capital management reporting. The goal of this document is to provide an overview of both of these categories, and include real-life examples of reporting performed by businesses in various types of industries.

Cash Flow Forecasting

The life-blood of any business is cash. For CFOs and corporate treasurers, managing and tracking cash flow is normally top of mind. There can be a number of reasons that a business needs to forecast its cash flow. These include but are not limited to:

* Businesses tight on cash need to make sure there will be enough cash to meet future payroll, or pay the rent.

* Growing businesses need to be able to plan for capital spending to support expansion, and will need to understand timing of free cash available for capital expenditures.

* Businesses seeking financing need to evaluate their ability to repay the debt.

* Businesses with excess cash to invest need to understand future cash requirements to enable them to optimize the maturity dates of various investments to ensure they have the cash liquidity they need when they need it. The better they understand future cash flows, the more they can maximize the returns on their invested cash.

Whatever the reason, it is clear that the ability to forecast cash flows is paramount to the success of any business. A primary source of cash for nearly all businesses comes from accounts receivable (A/R). Therefore, the ability to forecast cash receipts from A/R becomes an integral part of any effective cash flow forecast. Here, the credit department can become a valuable resource to the CFO or corporate treasurer by using their intimate knowledge of the company's A/R portfolio to provide a reliable forecast of future cash inflows for incorporation into a comprehensive cash flow forecast.

There are two methodologies to forecasting cash inflows from accounts receivable: near-term cash receipts and long-term cash receipts. Both are necessary and essential for a complete cash flow forecast. The near-term method relies on customer-level data that shows individual customer payment trends. The long-term method relies on sales forecasts and the days sales outstanding (DSO) calculation.

Near-Term Cash Flow Forecast

The near-term cash flow forecast uses existing A/R balances by customer to estimate when those balances will be paid. It does this by using customer payment trends, which are determined by taking customer payment history and calculating the average number of days from invoice date to the date of receipt of payment, commonly referred to as "average days to pay" Many A/R management systems have a built-in average days to pay calculation that can be used for obtaining a near-term cash flow forecast, but it can also be computed manually.

The first step is to gather historical data on each customer's payment history. The following information is required for each paid invoice for each customer:

* Invoice date

* Invoice amount

* Payment receipt date

Alternatively, it may also be necessary to include the payment amount in cases where deductions for cash discounts or other types of deductions are customary. Once the data is collected, each customer's average days to pay can he calculated in one of two ways: a straight averaging method or a weighted averaging method. In cases where invoice amounts are fairly consistent, or the days to pay is consistent regardless of invoice amount, the straight averaging method will work. However, if a customer's payment trend varies depending on the dollar amount of the invoice, the weighted averaging method should be used to get the best results.

Figure 1 shows the difference between the straight averaging and weighted averaging methods. The straight average is calculated by taking the sum of Days to Pay and dividing by the number of payments. In this example, the straight average is 46.8 days. However, a quick scan of the data reveals that except for a small invoice that took 94 days to get paid, the customer is generally paying in 35 days and the one small invoice is clearly an anomaly. The weighted average is calculated by multiplying each Amount Paid by the corresponding Days to Pay, summing the numbers produced, then dividing that number by the sum of the paid amounts. The weighted average method mitigates the effect of the one anomaly, and renders a result more closely representative of the customer's true payment trends.

Once the average days to pay has been determined for each customer, this information can be applied to current unpaid invoices to forecast future cash receipts. Figure 2 shows how dates and amounts of future cash receipts are determined. This data can then be summed by day or week to provide the CFO or corporate treasurer with a daily or weekly near-term cash flow forecast--depending on their preference--for inclusion into their cash flow model.

Since the near-term cash inflows forecast uses existing A/R, it is limited as to how far in the future it can forecast. Generally, this amount of time coincides with the company's average DSO. Beyond that, it relies on sales data not yet in A/R. To forecast cash inflows beyond what can be determined from A/R requires the employment of the long-term forecast method.

Long-Term Cash Flow Forecast

The long-term cash flow forecast uses the DSO calculation and applies this to a forecast of future sales. The sales department should be able to provide a monthly sales forecast. Armed with the sales forecast and the DSO calculation, monthly A/R balances can be calculated, and a long-term cash flow forecast can be calculated from the month-to-month A/R changes. Figure 3 shows how a forecast of future monthly cash inflows is calculated. Once the sales forecast and DSO are determined, the ending A/R balance can be determined. From there, the following simple equation will net the expected cash inflow for each month:

Figure 2

             Invoice      Inv.       Days     Payment
Customer      Date       Amount     to Pay     Date

ABC Corp.   2/12/2013    $300.00      35     3/19/2013
ABC Corp.   2/18/2013    $400.00      35     3/25/2013
ABC Corp.   2/25/2013    $400.00      35     4/1/2013
Acme LLC    2/8/2013    $1,000.00     40     3/20/2013
Acme LLC    2/22/2013   $1,200.00     40     4/3/2013
XYZ Inc.    2/14/2013    $700.00      32     3/18/2013
XYZInc.     2/21/2013    $800.00      32     3/25/2013
XYZ Inc.    2/28/2013    $600.00      32     4/1/2013
XYZ Inc.    3/7/2013     $700.00      32     4/8/2013

Figure 3

                 Mar-13   Apr-13   May-13   Jun-13   Jul-13

Monthly Sales    $8,400   $7,400   $8,300   $9,000   $6,800
Forecast (000)

Projected A/R    $7,396   $8,126   $8,383   $8,686   $8,383
Balance (000)
(DSO = 32)

Cash Inflows     $7,730   $6,670   $8,043   $8,697   $7,103
from A/R (000)

                 Aug-13   Sep-13   Oct-13   Nov-13   Dec-13

Monthly Sales    $7,800   $7,300   $7,600   $6,500   $5,900
Forecast (000)

Projected A/R    $8,209   $7,617   $7,896   $7,525   $6,957
Balance (000)
(DSO = 32)

Cash Inflows     $7,974   $7,891   $7,322   $6,870   $6,469
from A/R (000)

Prior Month Ending A/R Balance + Current Month Sales Current Month Ending A/R Balance = Current Month Cash Inflow from A/R

It is important to remember that if there is any expected cash discounting or other expected deduction activity, this must be taken into account to determine a true cash forecast amount.

Working Capital Management

In addition to having a reliable understanding of future cash flows, CFOs and corporate treasurers also need to understand how much cash is tied up in working capital. Successful businesses are able to minimize the amount of cash committed to working capital and are able to do this by effectively managing its individual elements. Working capital is the sum of A/R plus inventory less accounts payable (A/P). For CFOs and corporate treasurers, the ability to understand how effective the organization is managing these elements is essential to the overall management of working capital. The credit department is in a unique position with the ability to manage A/R and can be a valuable source of information on the effectiveness of managing this key component of working capital.

Days Sales Outstanding

At a high level, the most common measure of A/R management is DSO. Earlier, DSO was used in developing a long-term cash forecast. The higher the DSO number, the higher the A/R balance. Therefore, efforts to lower DSO have a direct positive impact on the amount of cash tied up in working capital. A DSO calculation for any given month is informational, but not particularly effective for managing working capital. What is far more meaningful to a CFO or corporate treasurer is the trend in DSO over time. If the DSO is increasing, then more cash is being committed and working capital management is becoming less effective. Conversely, a declining DSO demonstrates an improvement in working capital management. A simple chart like Figure 4 provides CFOs and corporate treasurers with an effective visual of the credit department's ability to assist the organization in managing this important aspect of working capital.

This example shows an overall improvement in AIR management signified by the declining monthly DSO and is an indicator to the CFO or corporate treasurer that the amount of cash tied up in working capital is declining.

It is important to note that the DSO has certain inherent shortcomings when used as a measure of A/R management effectiveness. Significant volatility in monthly sales volume can cause DSO to increase or decrease even when the level of effectiveness by the credit department has remained constant. Extending the time horizon for calculating average daily sales to three, six, or even 12 months will help to reduce the volatility, but may also skew the resulting forecast of cash inflows since the sales volatility will have a direct impact on cash flow. Keeping in mind the purpose of the DSO measurement (cash flow forecasting versus A/R management effectiveness) will be important in evaluating the trends and communicating this information to other areas of the organization.

It is important to note that the DSO has certain inherent shortcomings when used as a measure of A/R management effectiveness.

For purposes of reporting AIR and collections effectiveness to management, there are other approaches that can prove to be more accurate, meaningful and actionable. The next section explores these various reports.

Bad Debt Reporting

Bad debt expense occurs when the business loses confidence in the debtor party's ability or willingness to pay the business to settle debt. A business can lose confidence in debtor's ability to pay for variety of reasons, such as the debtor refusing to pay when asked, or the company undergoing financial difficulties such as bankruptcy.

The smaller bad debt expense is as a percentage of net terms revenue, the better. Increasing larger bad debt expense over time can be caused by external conditions, such as a worsening economy, but it may also mean that the credit policy is not appropriate for the business and may require a tighter approach.

Collections Reporting

In addition to measuring monthly DSO, many companies report on other collection metrics, such as:

* Best Possible DSO (BPDSO): Measures only the current portion of receivables. The closer DSO is to the Best Possible DSO, the closer the receivables are to the optimal level. Best Possible DSO is calculated as:

Current receivables x Period days / Month-to-Date (MTD) sales

* Average Days Delinquent (ADD): Measures the difference between the DSO and BPDSO


* Collection Effectiveness Index (CEI): Focuses on the quality of collection efforts over time by determining the percentage of open receivables an organization is able to recover or resolve within a given time period. CEI can also provide valuable insight into the strength and administration of an organization's credit policy. The higher the CEI, the more likely the organization is making sound decisions based on well-constructed guidelines. As the CEI drops, organizations should re-examine their credit policy, as this may be an indication that they are extending credit to companies that are not truly creditworthy. CEI is calculated as follows:

Opening Total Receivables--Ending Total Receivables + MTD Sales x 100

* Days Beyond Terms (DBT): Measures time it takes a business to pay its bills past the due date. DBT is calculated as:

MTD Days Late / MTD Payments

* Average Days to Pay (ADP): Measures the average number of days to pay for all invoices.

MTD Sales = sum of Amount Due for the period

MTD Days Late = sum of (Payment Date--Due Date) x Payment Amount

MTD Payments = sum of Payment Amounts for the month

MTD Days Pay = sum of (Payment Date--Invoice Date) x Payment Amount

* Top X Delinquent Accounts: The number of accounts depends on what measure is determined by management and size of company.

* Total AR Past Terms: Can be measured at different points of aging, depending on what interests company management:

* 60 days past terms (60+)

* 90 days and older (90+)

* 180 days and older (180+)

Finally, other metrics reports that management may want to see can include:

* AR as a % of Sales

* 90 + days (from invoice date) as a % of Sales

* Service Charge Income (service charges not booked until collected): Service charge income can counter bad debt expense to have a positive impact on the profit and loss statement.

* Write Offs: Write off reporting measures the point at which accounts are fully reserved for and written off. These can be the frequency of write offs (monthly, bi-monthly, quarterly, yearly), as reported by branch or location or as reported by the customer.

* Point of Sales Errors: Customers sometimes hold payment until credits are issued or disputes resolved causing delay in payment.

* Allowed Discount (earned discount / unearned discount)

* Collection Agencies' % of Recovery versus Cost

* Attorney % of Recovery Versus Cost

* Application % Approved--% Declined

* Bad Debt Expense (BDE): Are secured receivables allowed to age out longer than unsecured receivables before being reserved for versus unsecured receivables (secured with lien or bond rights)? At what point are receivables reserved for BDE? Is it done by increasing the percentage being reserved each month until balance is fully reserved at which time they are written off?


BDE aging days 30 60 90 120 150180 210 240 270 300 330 360 720 720+

Unsecured reserved as % of sales: 10% 20% 30% 50% 60% 70% 80% 100% 100% 100% 100% 100%

Secured reserved as % of sales: 30% 50% 60% 70% 80% 100% 100% 100% 100% 100%

"Reporting to Management" was written by Sue Herman, CCE, regional credit manager at Allied Building Products Corporation, Steven Porter, CCE, CTP, chief financial officer at First Aid Only, Inc. and Gosia Sanders, senior credit analyst at Google, Inc.

Figure 1

Invoice Date   Amount Paid     Payment Date     Days to Pay

11/16/2012       $100.00        2/18/2013           94
1/14/2013       $1,500.00       2/18/2013           35
1/22/2013        $700.00        2/25/2013           34
1/28/2013        $300.00         3/4/2013           35
2/5/2013         $400.00        3/13/2013           36
                             Straight Average      46.8
                             Weighted Average      36.9
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Title Annotation:GCSFM[R]
Publication:Business Credit
Date:Nov 1, 2013
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